Inflation is returning, how will it affect the economy?

After a long cycle of price stability inflation seems to return around the world. Central bank stimuli to create inflation and rising oil prices are helping. We analyze all the causes and effects that inflation will have on the economy.

Inflation in the eurozone reached 0.6% in November, its highest value since April 2014. According to data published on 30 November by the European agency Eurostat , this figure should not be surprising if we remember that policy Of the European Central Bank in recent years has precisely the objective of stimulating the economy by generating inflation. However, the rebound in prices is also a reality in other world economies (especially in the United Kingdom, the United States and Asia), which means that it is not a strictly European phenomenon and that it has deeper causes.

Why does inflation return?

Based on an analysis of the trends of the world economy in recent years, we can find several factors that act on the largest economies in the world in a more or less similar way, and whose joint action at least partially explains the increase in inflation.

First, the years of deflationary risk and weak growth may have led to a phenomenon of postponement of consumer decisions, i.e. a pessimistic scenario where consumers decide to wait indefinitely to spend, in anticipation that prices will follow going down. The end of this trend could mark the end of the deflationary cycle, but we must not forget the action of two exogenous factors that characterized the year 2016: volatility in oil prices (allowing for a possible recovery in the medium term) and the main currencies of the world (mainly the dollar, the euro and the pound).

In the United States, inflationary pressures are likely to be clearer. It is important to remember that the first economy in the world has opted for aggressive monetary policies to boost growth, which has allowed the unemployment rate to be reduced to 4.7% and to reach full employment. But regardless of the effects that such expansive cycles often have on prices (some of which are already being seen in the Consumer Price Index), Donald Trump’s victory in the presidential elections opens a stage where greater Increase in inflation. It should be remembered that the President-elect’s program includes strong tax cuts and minimum wage increases (in addition to an ambitious infrastructure plan), which would increase the monetary base and generate inflation.

On the other hand, the protectionist turn in trade policy could also push up prices. This new scenario is assumed by the Federal Reserve, and that is why it has decided to raise interest rates again, in order to moderate with monetary policy the inflationary pressures derived from tariff and fiscal policy.

Donald Trump’s victory in the presidential election opens a stage where further inflation is expected.

In the Far East economies we can also find a similar conjunction of structural and conjectural factors. On the one hand, wage growth (especially in Southeast Asia) and expansive monetary policies (as in Japan) have led to an increase in the monetary base, pushing up prices.

A similar effect could have the rebound of the oil, since many economies of the region are excessively dependent on the petroleum. Finally, it is also possible to speak of a “Trump effect” in the foreign exchange market: as a result of the election results (and bearing in mind that the president-elect has affirmed on numerous occasions his willingness to review trade agreements in the area Of the Pacific) most of the currencies in the region have been heavily depreciated, causing a rise in imports.

The United Kingdom seems a more singular case, although it is undeniable that the Brexit and the consequent depreciation of the pound (as is often the case when an economy with an exporting vocation and without commodities suffers declines in the price of its currency) is already being translated In the increase of the interior prices. Nevertheless, the uncertainty about its future does not allow assuring a scenario of higher inflation, mainly for two reasons: first, its exit from the European Union will allow him to make an independent monetary policy (being able to maintain the bias expansive or to return to restrictive, According to the needs of their own economy).

On the other hand, the possible reappearance of tariff barriers with the EU could make imports more expensive, but this effect could be mitigated by the signing of a new trade agreement or even by new bilateral agreements with third countries that can supply British importers at prices More competitive than Europeans.

In the European Union, meanwhile, the return of inflation appears somewhat further. As we have already mentioned, inflation in the eurozone in November reached 0.6%, which is a high in the last two years but still falls far short of the 2% target set by the European Central Bank. It is also important to consider that core inflation has not moved in 3 months by 0.8% and therefore, the effect of oil on the general level of prices is still limited.

For this reason, although forecasts point to more inflationary scenarios (with rates of 1.5% for the first quarter of 2017, according to Citigroup), the moderation of price increases relative to other economies may be a respite for a continent where growth is still weak and employment has not yet recovered.

What effects would inflation have?

Contrary to the perception of much public opinion, a moderate level of inflation tends to have beneficial effects on the economy. In the short run, the end of a deflationary cycle could facilitate an increase in aggregate demand as households could realize all consumer decisions that they had been postponing until then.

Similarly, highly indebted economies would benefit by the gradual depreciation of their liabilities. In the long term, the prospect of a price increase tends to improve the forecast of corporate profits, which tends to result in increases in stock markets and in growth in domestic and foreign investment. In addition, the arrival of capital to the country could be further strengthened if interest rates also increase, accompanying the movement of prices.

A moderate level of inflation tends to have beneficial effects on the economy.

However, inflation can also have profoundly negative effects, the most important being the loss of purchasing power by consumers. In economies with a flexible labor market and full employment this may not be a problem (since nominal wages could be adjusted automatically), but in economies with high unemployment rates or large structural rigidities real wages could be reduced, especially if the authorities They bet on the internal devaluation as a growth engine.

On the other hand, if interest rates do not accompany the movement of prices, the yield on financial assets could fall below inflation, thus penalizing savings. Finally, an increase in the overall level of prices could reduce the competitiveness of some economies, especially those with characteristics such as greater reliance on exports to grow or excessive exposure to oil.

If they are also production models based on price competitiveness rather than on value added (as is the case with countries that export raw materials or semi-finished products), exports could be seriously damaged and the risk of a currency war could grow.

The fact is that, regardless of their possible effects on the global economy (and on each country in particular), the increase in prices seems to be consolidating every day as a reality closer to consumers, although there is still some uncertainty about it. In this sense, the year 2016 will possibly be remembered as the year of political instability and currency volatility. Will 2017 be the year of the return of inflation?

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